The other terminal rate: How far will policy rates be cut?

Recent communication by the Federal Reserve and the ECB has made it clear that the first cut in official interest rates is coming. Both central banks are saying the same -it depends on the data- but the ECB communication is more opaque than that of the Federal Reserve, which provides interest rate projections of the FOMC members (dot plot). In assessing how fast and how much the ECB might cut policy rates in this cycle, several approaches can be adopted. Based on the credibility of the ECB and plausible estimates of the neutral rate, it makes sense to use an assumption of a range between 2.00% and 2.50% for the ECB deposit rate as the end point of the easing cycle.

Recent communication by the Federal Reserve and the ECB has made it clear that the first cut in official interest rates is coming. On the presentation of the semiannual monetary policy report to the Congress, Jerome Powell stated that the FOMC is waiting to become more confident that inflation is sustainably moving to 2%, adding “When we do get that confidence — and we’re not far from it — it’ll be appropriate to begin to dial back the level of restriction.”[1] In his press conference on 20 March following the FOMC meeting, he confirmed the message that policy easing will start this year.[2] Earlier this month, Christine Lagarde had mentioned during her press conference that the ECB is making good progress towards its inflation target but that more data are needed to be sufficiently confident that the inflation target will be reached. “We will know a little more in April, but we will know a lot more in June.”[3] So far for the easy question -will there be a rate cut?- so let’s move on to the difficult questions of how many cuts and how fast. What will be the ‘other’ terminal rate, i.e. the rate at which central banks will stop reducing their policy rate.[4] At first glance, both central banks are saying the same -it depends on the data- but upon closer inspection, the ECB communication is more opaque than that of the Federal Reserve. During his press conference, Jerome Powell referred to the FOMC members’ projections for the federal funds rate (the ‘dot plot’). “If the economy evolves as projected, the median participant projects that the appropriate level of the federal funds rate will be 4.6 percent at the end of this year, 3.9 percent at the end of 2025, and 3.1 percent at the end of 2026—still above the median longer-term funds rate.”[5] Clearly, given the data-dependency of policy, the policy rate path decided by the Fed would be different should the economy evolve differently than expected. Nevertheless, the dot plot provides a clear picture of the base scenario that the FOMC members have in mind and serves as a good reference point for economic agents. Speaking at the recent ECB Watchers conference, Christine Lagarde stated “We cannot precommit to a particular rate path however tempting that is, however much some of you would like to see it. If we are honest to our methodology and if we have discipline in adhering to this principle, we cannot.”[6] The absence of guidance on Eurozone policy rates -there is no ECB dot plot- raises two questions: does it matter, and, how should one go about in assessing how far rates could be cut? Concerning the former, in theory, one would expect a positive impact on macroeconomic performance from publishing interest rate projections. They should lower the uncertainty about the future interest rate path. Consequently, households and companies may be more eager to react to the prospect of rate cuts as reflected in these projections than to those that can be inferred from financial markets and which are inherently more volatile. Interest rate uncertainty matters because of its negative impact on firm decisions.[7] However, one should be mindful that major changes in the interest rate projections could increase uncertainty by wrongfooting markets, households and firms.

At the current juncture, the more relevant question in the Eurozone is how fast and how much policy rates might be cut in this cycle under the hypothesis that key economic variables -inflation, growth, wages, etc.- would evolve in line with the latest ECB staff projections. Several approaches could be adopted (table). The first consists of looking at the consensus forecast. The latest ECB Survey of Monetary Analysts (March 2024) sees the deposit rate, which is currently at 4.00%, dropping to 3.00% at the end of this year, 2.25% at the end of 2025 before reaching its long-term projection of 2.00% in 2027. Secondly, one could look at market pricing. Based on the euro short-term rate (€STR) forward curve, markets expect a decline in the deposit rate of 85 basis points (bp) by the end of this year and 150 bp by the end of 2025 (chart 1). However, market pricing can fluctuate significantly, in reaction to data surprises and comments of ECB governing council members. A shown in chart 2, based on €STR futures, the implied interest rate for December 2024 had dropped about 120 basis points in the fourth quarter of 2023, before rising again approximately 80 basis points. Clearly, the stability of the deposit rate -the last hike occurred at the September 2023 governing council meeting-, did not stop market pricing for the future path to be very volatile.

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